By Charley Babb
The recent volatility in the stock and bond markets has many investors on the edge of their seats. This is understandable as all of the gains that took the various US equity indices to record highs earlier this year have been erased, and the index will finish the year below where they began in January 2018. US bonds have been in favor in the past few weeks in a flight to safety resulting in a 10-year US Treasury (“10UST”) yield of 2.70% as of the writing of this article. This is down from a 52-week high of 3.26% not long ago. While this is still higher than the 52-week low of 2.41%, it is indeed a positive change for borrowers of loan products that utilize the 10UST as an index for setting interest rates.
There are many theories as to why the stock market has become so bearish in recent weeks. The congressional impasse with President Trump on government funding has us in the second week of a US Government shutdown. Trade tensions with China are spooking many investors. The decision by the Federal Reserve on December 19th to raise its benchmark short-term rate to 2.5% is the fourth quarter point rate hike this year and the ninth increase since the end of 2015. The thirty-day LIBOR (“30LIBOR”) rate will close the year at 2.51%, up from 1.56% a year ago and the US Prime rate is at 5.5%, up from 4.5% this time last year. That has some investors speculating that the Fed is applying the brakes to the economy too firmly and the resulting flat yield curve is portending a recession. The irony here is that the Fed continues to raise rates precisely because they hold a view that the economy is strong and will continue to perform well despite the current headwinds.
Whatever the reasons for the current state of affairs in the capital markets, the abrupt turnabout is creating opportunities for savvy borrowers. The first and most obvious opportunity for borrowers on the fence about locking into a 10-year fixed-rate loan; they just got a New Year’s gift. While spreads have widened as the 10UST has moved in, effective interest rates are down a bit from where we were 60 days ago. This might be an excellent time to apply for the long-term, fixed-rate mortgage they were contemplating.
Possibly less obvious, but certainly relevant to those who are currently or soon entering into floating interest rate products, interest rate caps are on sale. The cost of the rate caps has dropped dramatically over the last 30 days. With current interest rate levels retreating, the futures curves have created a much more attractive environment and pricing for structures and strategies to mitigate interest rate risk. Some interest rate cap costs have plummeted by as much as 50% in the last month. For instance, a two-year rate cap with a 30LIBOR strike price of 3.0% would only cost 20 basis points today, and a three-year cap would only cost 46 basis points.
Should one currently have a loan that matures in the next couple of years, and they are concerned about rising interest rates at that time, another possible option to consider is the purchase of an interest rate swaption. For an upfront fee, a swaption allows a borrower to cap their fixed-term financing rate at a level based upon current rates (the strike interest rate), to hedge that future financing need. The borrower has the right but not the obligation to exercise the option in the future depending upon where actual rates are at that time. If interest rates are higher than the swaption’s strike rate, the swaption will compensate the borrower for the difference. If interest rates are lower, it is analogous to purchasing auto insurance and not having an accident. The borrower can enter into a loan at a lower rate than the swaption rate. Just like rate caps, swaptions can be highly customized and tailored to the needs of the borrower. Now is an excellent time to consider this strategy if it applies to you.
As is often the case, volatility in some markets can create opportunities in others. Some borrowers can certainly take advantage of the current state of affairs. We stand ready to assist you no matter the situation in which you currently find yourself.
The author, Charley Babb, is a Principal and Senior Director at Metropolitan Capital Advisors. Charley may be reached at 303-598-7652 or [email protected]